This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

February 11, 2013

Daily Changes to ETF Premiums Can Be Predicted in Advance: Morningstar

New research offers insight—and investment opportunity—based on the way ETF premiums and discounts behave

Daily changes to exchange-traded fund premiums can be predicted in advance with a reliable degree of accuracy by using easily obtained information, says new Morningstar research released Monday.

ETFs are a relatively new investment type, so little has been understood until now about the periodic dislocations between ETF market prices and the discounts or premiums of their underlying net asset values, according to Morningstar analyst Lee Davidson, author of “Examining the Exchange-Traded Nature of Exchange-Traded Funds.”

ETF premiums can be modeled, and daily changes to ETF premiums “show a strong relationship to contemporaneous and lagged movements in the equity market, equity market volatility, and equity market liquidity,” Davidson wrote in his 47-page report. “A larger change in one variable today tends to coincide with a larger change to an ETF’s premium both tomorrow and the day after.”

The Morningstar findings are significant because knowing how ETF premiums and discounts behave can help investors improve trade execution and save money.

“In some cases, putting this knowledge to use for a single transaction could have covered the entire annual expense ratio of the ETF purchased,” Davidson wrote. “For the ETF investor, the conclusions of this paper suggest that cost-conscious investors should seek to trade ETFs intelligently and patiently using information readily available today in order to avoid transacting at unfavorable prices tomorrow.”

In addition, active ETF managers can create trading strategies using these relationships as indicators to generate abnormal returns before transaction costs, Davidson said.

Highlights of the report:

A “naïve” trading strategy can be constructed to take advantage of the predictability of ETF premiums to generate abnormal returns with an average annualized Carhart alpha of 7.22% per year, ignoring costs.

ETFs are highly efficient on average, but extremely inefficient at times. Being able to anticipate when inefficiencies in ETFs’ pricing will occur matters for trade execution.

Davidson’s approach to modeling ETF premiums focuses on the day-to-day changes to an ETF’s premium by creating a daily rebalancing long-short portfolio that goes long the ETF and short the underlying shares. The returns effectively represent an investment strategy that receives the ETF market return and pays the ETF NAV return each day.